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March 24, 2014

6 IRA Investing Mistakes to Avoid

For investors in Roth and traditional IRAs, Morningstar says procrastination is one of the common errors that can add to your tax burden

Morningstar lists six common errors investors make that can raise their tax bill.

As the April 15 tax filing deadline approaches, procrastinators are scrambling to finish their 2013 tax year returns. The clock is also ticking for IRA contributions that will count for the 2013 tax year.

Investors who wait until the eleventh hour will forgo the benefit of timelier contributions, but this not the only mistake that can trip up even savvy investors when it comes to their IRA contributions.

A recent article on Morningstar lists six common errors investors make in addressing this important retirement savings vehicle:

Mistake 1: Waiting until the last minute

A large segment of IRA contributors for the 2013 tax year will lose 15 months of tax-advantaged compounding because they will have waited until the tax-filing deadline to make a contribution rather than doing so at the beginning of the tax year (Jan. 1, 2013), according to Vanguard research on the topic. Over time, missing out on this compounding benefit can add up to serious money. And even investors who fund their IRAs may delay in selecting their investments, which can also weigh on returns over time. Morningstar says younger investors, in particular, should make a point of getting their IRA contributions invested in long-term securities at the earliest opportunity.

Mistake 2: Thinking of Roth vs. traditional as an either-or decision

It can be a mistake to think about Roth and traditional in exclusive terms. Many investors end up with a blend of traditional IRA and Roth accounts, either by happenstance or by design, according to Morningstar. For example, someone who could contribute to a traditional IRA in the past may no longer be able to deduct the contribution because of income limits, but can still fund a Roth IRA.

Moreover, the idea of tax diversification argues for building balances in taxable, tax-deferred and Roth accounts. For one thing, few investors can forecast whether their tax rates will be higher or lower in retirement than they are now, so holding multiple accounts is a good way to hedge against multiple outcomes. Income levels during working years may also fluctuate: A low tax-rate year can be a good time to fund a Roth, while a deductible traditional IRA contribution can be more valuable when your tax rate is higher. In addition, holding taxable, Roth and tax-deferred accounts gives a retired investor the ability to obtain varying tax treatments of withdrawals, thereby keeping taxable income lower. Investors can even split their contributions among each account type in a single tax year, so long as total contributions don’t exceed $5,550 for those under 50 and $6,500 for those older than 50.

Mistake 3: Making a nondeductible IRA contribution for the long haul

Investors who earn too much to fund a Roth IRA (and by extension earn too much to deduct their traditional IRA contribution because of even lower income limits) can still open a traditional account and then convert it to a Roth — a potentially valuable maneuver for many high-income savers because there are no income limits on conversions. But opening a traditional, nondeductible IRA and not converting those assets to a Roth is almost never a good idea, according to Morningstar. True, the traditional IRA provides tax-deferred compounding, but that can also be had by buying tax-efficient investments inside the taxable account. Moreover, the capital gains rate on long-held taxable assets is more attractive than the tax on IRA distributions, which will incur ordinary income tax rate on any money that hasn’t been taxed yet.

Mistake 4: Assuming a Backdoor IRA contribution will be tax-free

Investors who earn too much to contribute to a Roth IRA directly can open a traditional, nondeductible IRA and convert it to a Roth; there is no income limit on traditional IRAs or conversions. Absent any other IRA assets, the only tax owed upon conversion will be on any appreciation in the assets that occurred from the time the account was opened to when it was converted.

However, Morningstar notes that backdoor conversion may not be a good idea for investors with other IRA assets that haven't been taxed yet — say money rolled over from a traditional 401(k) with a former employer. In that case, the taxes due on the conversion will be based on the ratio of already-been-taxed IRA assets to those that have never been taxed (pretax contributions, including traditional 401(k) rollover money, and investment earnings). If the former number is much smaller than the latter, the conversion will be mostly taxable.

Mistake 5: Falling prey to analysis paralysis

Income limits and tax treatment of contributions and withdrawals for different IRA types vary significantly and can be difficult to understand. But letting fear of selecting the wrong IRA wrapper block any decision at all is not an option. Thanks to an escape hatch called recharacterization, an investor can switch to the IRA wrapper he should have chosen in the first place — Roth instead of traditional or vice versa. However, this do-over mechanism doesn’t enable the investor to recharacterize an IRA just because his investment choices turned out badly.

Mistake 6: Not contributing later in life.

IRA contributions made later in life will benefit less from tax-free (Roth) or tax-deferred (traditional IRA) compounding than will contributions made earlier in life. But investors should not forget IRA contributions in the years leading up to and during retirement, Morningstar says. For one thing, they may have quite a few years of tax-advantaged compounding left. And investors in a Roth IRA won’t need to take distributions from their account unless they need the money as there are no required minimum distributions. This means their money could continue to compound even after retirement.

Investors should also keep in mind that they can start contributing an extra $1,000 to an IRA at the beginning of the year in which they turn 50 (for a total contribution of $6,500). And although they can’t fund a traditional IRA past age 70 1/2, they can contribute to a Roth at any age, as long as there is enough earned income to cover the contribution amount.